June 28, 2010 United States: Financial Services The debate is largely over, but many details still to come Nearing the end of Congressional reform Next Steps: A speedy passage from here Passage of the financial service reform bill We expect final passage of the legislation should IMPLEMENTATION TIMELINES BY PROPOSAL represents an important milestone that will occur quickly. The House is expected to vote on Volcker Effective Enactment Study Rulemaking Compliance alleviate some of the uncertainty that has been the legislation this week, followed soon thereafter Date weighing on the sector. We expect investor focus by the Senate. While the legislation cannot be July, 2010 January, 2011 September, 2011 July, 2012 July, 2014 (potential for up 3 year extension) to migrate to operational trends as the debate amended, there is likely to be further activity in Derivatives 2012: Effective Date for 2012‐2014: Transition 2015: Optional around the impact of reform on normalized coming months to clarify congressional intent. Banks to set up separately period to move derivatives Transition Period earnings subsides. That said, while the big issues capitalized swap subsidiary to new subsidiary Capital Requirements (TruPS treatment) TruPS excluded from have been settled, some uncertainty remains as This is not necessarily the end of fin-reg Applies to banks with Phase out period begins Tier 1 capital assets > $15 bn 2013 many aspects of the proposed legislation require There is a long phase-in period in which the actual 2016 interpretation and specific rule making by rules will be crafted by regulators. While this may Regulatory Assessment September September September September $19 billion bill cost regulators. lead to further surprises down the line, we see this 2012 2013 2014 2015 as important as financial institutions have time to Annual Assessments paid annually Final bill largely in-line with expectations adapt their business models. Other issues which Source: Goldman Sachs Research. Language around the swap push-out provision, are still on the table include a potential TARP tax, We would like to thank Alec Phillips for his contributions to debit interchange and the Collins amendment GSE reform as well as Basel 3. this report ended up being more manageable for the industry than many feared. The Volcker rule is more Stock implications: banks & exchanges mixed; language on prop trading is slightly more Banks are the most impacted, and unknowns have restrictive, while hedge fund/PE ownership is less been reduced, thus valuation may improve and restrictive. One surprise was a $19 bn “fee” that fundamentals should become more important; we will be borne by the industry for the cost of the like JPM, BAC and C. In addition, exchanges are bill, although it will be spread over a broad range positioned to benefit from new regulation. CME of financial institutions and not just banks. and NDAQ are our favorite stocks in exchanges. Richard Ramsden The Goldman Sachs Group, Inc. does and seeks to do business with (212) 357-9981 [email protected] Goldman Sachs & Co. companies covered in its research reports. As a result, investors should Brian Foran be aware that the firm may have a conflict of interest that could affect (212) 855-9908 [email protected] Goldman Sachs & Co. the objectivity of this report. Investors should consider this report as Daniel Harris, CFA only a single factor in making their investment decision. For Reg AC (212) 357-7512 [email protected] Goldman Sachs & Co. certification, see the end of the text. Other important disclosures follow Jessica Binder Graham, CFA the Reg AC certification, or go to www.gs.com/research/hedge.html. (212) 902-7693 [email protected] Goldman Sachs & Co. Analysts employed by non-US affiliates are not registered/qualified as research analysts with FINRA in the U.S. The Goldman Sachs Group, Inc. Global Investment Research June 28, 2010 United States: Financial Services Table of Contents Table of Contents 2 The debate is largely over, but many details still to come 3 Sector Impact 5 Volcker: Directionally similar – positive for alternatives and a hit to prop trading 9 Derivative legislation: swap push-out and clearing/trading clarity begins to emerge 10 Capital requirements: TruPS to be phased out from Tier 1, but more regulation to come 17 Resolution Authority: in-line with prior proposal, but still poses some risk to credit ratings 18 FDIC Assessment will be spread across a large number of financial firms and hedge funds 19 Debit Interchange – toward a “reasonable and proportional” world of debit 21 Merchant acquirers avoid the hot seat 24 Defining Qualified Residential Mortgages and the impact on Private Mortgage Insurers 25 Passing on the costs of regulatory burdens 27 GS Financials Equity Research Team Banks Insurance Asset Managers Market Structure & Real Estate/REITs Homebuilders Brokers Richard Ramsden Christopher M. Neczypor Marc Irizarry Dan Harris, CFA Jonathan Habermann Joshua Pollard Brian Foran Christopher Giovanni Alexander Blostein, CFA Jason Harbes, CFA Sloan Bohlen Anto Savarirajan Soumil Zaveri Eric Fraser Neha Killa Conor Fennerty Cooper McGuire Siddharth Raizada Vikas Jain GS Financials Credit Research Team Technology: IT Services Financials Specialist Banks Insurance and Managed Care Julio C. Quinteros Jr. Financials Sector Specialist Louise Pitt Donna Halverstadt John T. Williams Jessica Binder Graham, CFA Ron Perrotta Amanda Lynam Vincent Lin Pradeep Verghese Snigdha Sharma Goldman Sachs Global Investment Research 2 June 28, 2010 United States: Financial Services The debate is largely over, but many details still to come The debate around Financial Reform has provided clarity on well-discussed topics and reduced the ‘unknown’ impact of the process to a more manageable level, and provided guidance around the timeframe for implementation of the proposals. Volcker Rule: The outcome was directionally as expected compared with the previous proposal, with somewhat less restriction on hedge/private equity fund sponsorship and investment, as it allows firm investment up to 3% of Tier 1 capital, and allows for organization/offering of funds in certain cases. However, it is somewhat more restrictive on proprietary trading than the previous text. An exemption is included from the prop trading ban for market making and hedging, however, there is a separate requirement that prohibits conflicts of interest with any client or counterparty, subject to regulatory interpretation. Firms will have at least four years to adjust to the prop prohibition, although additional capital charges could be applied to prop activities sooner. Derivatives Legislation: This was the area of the greatest uncertainty heading into the last few days of negotiation. The final bill will allow banks to continue to serve as swap dealers for interest rate swaps, foreign exchange, cleared CDS on investment grade entities, and gold and silver-related swaps. Other swaps, including non-cleared CDS, commodities, and equity-related swaps, will be moved to a separate affiliate within the bank holding company structure. Our understanding is that banks will need to capitalize the subsidiary no sooner than two years, plus a period for transition. Importantly, the legislation exempts end users from clearing house requirements if the derivatives are being used to hedge or mitigate commercial risk (including balance sheet related risks) or are used to assist in selling the company’s products. Currently, we are unsure if existing contracts will be grandfathered. Resolution Authority: Language around the Resolution Authority did not significantly change over the course of the conference. The Resolution Authority gives the FDIC power to unwind failing financial firms and explicitly bars the use of taxpayer funds to rescue them. As current credit ratings assume some level of government support, one of the concerns is that there are likely to be rating downgrades now that this support is not guaranteed. However, the rating agencies have said there will be some offset which will be determined by firm profitability and the macroeconomic backdrop. Capital requirements: Language mandating the removal of TruPS from Tier 1 capital was softened somewhat over the course of the Conference as the grandfathering provisions for existing TruPS makes implementation more manageable. In addition, the final bill contained some broad language suggesting that large, complex banks will need to maintain a significant level of capital in the future. Consumer Protection / Debit Interchange: The bill creates a Consumer Financial Protection Bureau to be created within the Federal Reserve. The director of the new agency will be a Presidential appointee subject to Senate approval. It will have rule-making and enforcement powers over banks and other financial companies. The Fed is permitted to limit the fees charged to merchants by banks and credit card companies each time a debit card is used. Federal Insurance Office (“FIO”): While the full impact of systemic risk delegations is still unclear for insurance companies, the overall regulatory structure has not changed for the industry. Specifically, the newly formed Federal Insurance Office does not appear to have regulatory authority, thus allowing for state-based regulation to remain the de-facto regulator. The initial goal of the Federal Insurance Office appears to be “monitoring” the industry; however, the bill also requires a study Goldman Sachs Global Investment Research 3 June 28, 2010 United States: Financial Services to be done within the next 18 months on how to modernize and improve the system of insurance regulation in the United States. FDIC Assessment: One of the surprises to the final bill was the addition of a $19 bn assessment through the FDIC on financial firms with assets over $50bn (including both Banks and Insurance Companies), and hedge funds over $10bn. This provision was added to offset the estimated cost of the bill, which was due in large part to the resolution authority and various administrative responsibilities created by the bill. There is some uncertainty on how this cost will be distributed across firms, and is expected to be scaled by riskiness.